Outside Opinion: Private regulation on the rise

A mourner holds up a portrait of a missing relative, presumed to have been killed in the Rana Plaza factory collapse in Savar, Bangladesh. (MUNIR UZ ZAMAN, Getty-AFP photo)

It often takes a human tragedy to put an issue on the agenda. The Rana Plaza factory collapse that killed more than 1,100 in Bangladesh was the deadliest disaster in the garment industry's history.

European companies that outsource clothing manufacturing to Bangladeshi factories agreed to a new safety and working conditions code. U.S. companies stayed out, citing liability fears, and came up with an alternative plan.

This is not an isolated case. This year Apple and its main manufacturing contractor, Foxconn, agreed to improve labor conditions at Chinese factories. This decision followed months of controversy over alleged illegal overtime and poor worker housing, as well as a string of reported suicides. Wal-Mart also has embraced sustainable supply chains after it faced controversy over environmental issues.

These cases illustrate an important phenomenon: the rise of private regulation of world commerce.

This regulation is fueled by activists, social media and public outrage. Many multinational companies now require their suppliers comply with global standards ranging from safety to labor conditions to minimum wage levels. Such requirements are not required by local law. Indeed, they usually dramatically exceed local practice. These rules and regulations have the same practical impact as traditional governmental regulation. A manufacturer that does not comply with Wal-Mart's environmental standards may be shut out from the U.S. market.

Governments play little to no role in such agreements. They are negotiated and enforced by private parties: companies and activist groups. This new form of regulation has sparked controversy. Recently, economists Jagdish Bhagwati and Amrita Narlikar have accused activists of bamboozling retail companies into taking responsibility for safety at garment factories, a burden that should rest on the factory owners. Exit doors existed, the scholars wrote, but managers closed them.

It is true that activists choose their targets for maximum impact, often focusing on famous consumer brands rather than the worst offender or the local manufacturer that has operating responsibility. My colleague Brayden King's research finds that when a company is boycotted, the targeted company sees an average decline in its stock price of 0.7 percent for each day it receives national media coverage. A company's decision to give in may mainly be the result of comparing the costs of compliance with the risk to its reputation if it keeps fighting.

Battles between companies and advocacy groups are "private politics," contests fought between interested parties in the arena of public opinion. As with all forms of politics, they involve campaigns, deal-making, and the art of the possible. Some critics question the legitimacy of such arrangements. They may have the same consequences as public regulations but do not involve elections and due process.

Nevertheless, private politics increasingly plays an important role where traditional regulatory approaches are absent or ineffective. Plagued by corruption, or simply the lack of state capacity, governments may be unable or unwilling to regulate. Safety and labor standards in diamond mines will not be enforced unless there is pressure from their customers — multinational companies that care about their reputation.

Bhagwati and Narlikar raise the prospect of companies pulling out of Bangladesh, now that they are on the hook for safety. Workers would lose their jobs, and in fact, Disney announced in May it would stop using Bangladeshi suppliers. That is why it is better for private regulation to extend across an entire industry, and not just apply to one country. Standards should apply to all suppliers, not just those in Bangladesh, which would lessen the incentives for companies to exit.

As with any form of regulation, private regulation can burden companies, their suppliers and customers. Yet such costs can be more than offset by social benefits such as a cleaner environment or the protection of human rights. In a world of expanded media coverage, globalization and rising public scrutiny of companies, private regulation will only grow. Companies need to be ready for this challenge. Simply ignoring this phenomenon will not make it go away.

Daniel Diermeier is IBM professor of regulation and competitive practice and director of the Ford Motor Company Center for Global Citizenship at Northwestern University's Kellogg School of Management.